It isn’t fun to consider how your real estate properties have deteriorated as they face another year of use by tenants, harsh weather conditions, aging building materials and other factors. However, when that deterioration results in tax deductions and increased cash flow, then maybe it isn’t so bad. When it comes to accounting books and tax returns, this deterioration is known as depreciation.
Depreciation is a standard phrase used in real estate, and investors can use it to their advantage. Uncover the intricacies of depreciation, how it can increase cash flow and why it’s valuable in a 1031 exchange.
What is depreciation?
The Internal Revenue Service (IRS) defines depreciation as the recovery of a property’s costs over a number of years. You recover this cost with an annual income tax deduction, and it accounts for factors such as wear and tear, deterioration and obsolescence of a property.
For real estate, depreciation is the calculation of loss of value on any improvements to a property. In most cases, land, as the basis of a property’s value, will not endure loss in value through wear and tear. Therefore, the value of the land doesn’t usually factor into a depreciation calculation. The buildings that are constructed on the land become the improvements eligible for depreciation deductions.
At a basic level, depreciation accounts for the portion of the property that decreases in value simply by using it, the portion of the property that can wear out and require replacing. Because nothing lasts forever, each use of a building is one use closer to making that building useless. There is a cost to fix a property in order to preserve that property’s usefulness for as long as possible. This cost reduces the value of the property and becomes an eligible tax deduction calculated as depreciation.
Types of Depreciation in a 1031 Exchange
There are two depreciation types following a 1031 exchange — two schedule and single schedule.
Two schedule depreciation is the preferred tax code method for calculating depreciation following a 1031 exchange. To calculate two schedule depreciation, you need the adjusted cost basis for the property you intend to exchange and the remaining cost basis of the replacement property.
The adjusted cost basis for the property you sell must be divided by 24.5 years. This rate is your first schedule of depreciation. The remaining cost basis of your replacement property must be divided by 27.5 years — the second schedule.
Single schedule depreciation is a more straightforward method but is not the calculation preferred by the tax code. To calculate this type of depreciation, divide the new adjusted cost basis of the asset by 27.5 years or 39 years for commercial properties. This rate represents annual depreciation.
How Does Depreciation Increase Cash Flow?
When a property is depreciated on a tax return and deductions are taken from the income earned on that property, you pay less tax to the IRS and, in turn, increase your net income. Your deprecation amount will also play a role in your operating cash flow. The calculation for operating cash flow starts with your net income, which is higher with the tax breaks you receive for depreciation.
Depreciation value then factors back into your net income in addition to the net change in operating working capital and other necessary adjustments. With depreciation added back into your net income, you gain a higher amount of cash on your cash flow statement.
A property may have a $12,000 annual pre-tax net cash flow but then will owe the IRS income taxes on that $12,000. By utilizing depreciation the taxable income amount owed to the IRS will be reduced. This allows a greater portion of that $12,000 to remain in the investor’s pocket, resulting in an increased after-tax net cash flow.
Why Is Depreciation Costing Me So Much?
Depreciation can lead to extensive expenses following the sale of a property. If depreciation can increase your cash flow, how can it also cost you? If a property’s sale price is higher than the cost basis of a property, the IRS will recapture your depreciation deductions. This system is similar to capital gains taxes.
If an investor depreciated a property by $50,000 over the time of ownership and reduced a property’s cost basis from $300,000 to $250,000 and then sells the property for $290,000, the investor will owe a significant percentage in depreciation recapture of that $40,000 difference.
Like capital gains tax, you can defer depreciation recapture through a 1031 exchange. Keeping depreciation in mind and understanding how it influences your investments can change your approach to investment strategy. Depreciation isn’t a straightforward tax strategy. In our next blog, we’ll look into a few other factors of depreciation.
Register at 1031 Crowdfunding to Find Your Next Property
At 1031 Crowdfunding, you can access our extensive collection of 1031 properties for exchange. Through these properties, you can defer depreciation recapture and increase your cash flow.
Our inventory of properties makes it easy to complete exchanges within the required time periods. Many of our clients complete exchanges in as little as a week. As a member, you’ll also gain support from our team of real estate experts who can help you make decisions based on your investment objectives.